Now that the plans for forming your new business are under
way, it would be wise to begin the process of selecting
which form of organization is best suited to your needs
as principal owner.

The choices typically are: a C corporation, an S corporation,
a limited liability company, a general partnership, or a
limited partnership. No single form is right for every owner.
Instead, the choice depends on the relative importance to
you of several key issues.

Key Factors Affecting Choice of Entity

This checklist is designed to give people a framework for
analyzing the major factors that typically affect the choice
of entity decision. Practitioners who wish to examine these
factors in more detail may wish to consult the Commentary
portion of this Title.

Formalities
of existence:
Of the major forms of business, C and S corporations have
the most burdensome requirements regarding formalities
of existence. These requirements reflect the fact that
a corporation is a separate legal entity from its owners.
A corporation must file articles of incorporation with
the secretary of the state in the jurisdiction of organization.
It must also adopt bylaws, elect a board to directors,
hold organizational meetings, and keep minutes thereof.
Although these are the general rules with regard to the
formalities a corporation must observe, each state has
its own incorporation requirements that must be examined
and observed.

A general partnership usually has no formal registration
requirements. It may be established informally without
a written agreement. A limited partnership, as a creature
of state statute, must observe certain formalities. In
particular, a certificate of limited partnership must
be filed with the secretary of the state of formation.
In addition, the partnership must follow the organizational
requirements imposed by that state.

Tax
aspects of formation:
When a C or an S corporation is formed, the owners generally
contribute property or services to the entity in exchange
for stock. If property is contributed, the owners do not
recognize gain on receipt of the stock provided they are
in control of the company. That is, if they own 80% or
more the voting power or 80% or more of all other classes
of stock. If, however, the contributors receive something
other than stock, i.e. cash, they must recognize gain
in the amount of the nonqualifying property received.
This rule also applies if the individual contributes property
subject to debt, i.e., the transferor is treated as having
received cash equal to the amount of the debt. An individual
who contributes services in exchange for stock must generally
recognize gain. However, the corporation may be able to
deduct the compensation to the extent it is not treated
as a capital expenditure.

The tax consequences of forming a partnership or a limited
liability company taxed as a partnership are similar to
those governing corporate formation. A contribution to
the entity in exchange for an ownership interest is generally
not a taxable event. However, the partnership non-recognition
rules are more liberal than the corporate rules in that
there is no requirement that the owners be in “control”
of the partnership after the contribution. If, however,
a partner contributes encumbered property to a partnership,
the receipt of such property is treated as a transfer
of cash to the contributing owner and is likely to be
treated as a partnership distribution equal to the amount
of the debt. Specifically, the other owners' share of
the liability is deemed to be distributed to the contributing
owner.
A partner who contributes services in exchange for a partnership
interest generally recognizes gain equal to the value
of the interest received. However, if the partner receives
only a right to future partnership profits as opposed
to a capital interest, then no gain is recognized.

Limited
liability of owners:
In general, the owners of a C or an S corporation are
not personally liable for the entity's obligations. However,
an owner who guarantees a debt or commits a tort while
acting on behalf of the entity may lose this protection.
This protection may also be lost if the corporate veil
is “pierced.” This can occur if the entity
either is poorly capitalized or fails to maintain a separate
identity from its owners.

A limited liability company also provides its owners with
limited liability. However, because these are state created
entities, and are relatively new, there is little uniformity
from state to state with respect to the extent of this
limited liability.

Unlike a corporation or a limited liability company, a
general partnership does not afford its owners limited
personal liability. The owners are personally liable for
partnership debts and for the acts of fellow owners performed
in furtherance of partnership business. General partners
in a limited partnership have the same type of personal
liability as do their counterparts in a general partnership.
However, the liability of limited partners who do not
manage the business is limited to the extent of their
respective investment in the enterprise.

Taxation
as separate entity versus pass-through entity:
One of the biggest factors affecting the choice of entity
decision is whether the entity should be taxed as a separate
entity or whether its items of income, credit, loss, and
deduction should pass-through and be reported by the owners
on their personal tax returns. C corporations are taxed
as separate entities. One disadvantage to a C corporation
is that its earnings can be taxed twice—once when
earned at the corporate level and again when distributed
to shareholders. This double taxation often can be minimized
in the context of closely held corporations, however,
if the entity pays out most or all of its earnings as
deductible salary (the amount must be reasonable) or rent.

S corporations, partnerships, and limited liability companies
taxed as partnerships provide pass-through treatment.
In general, there is no entity-level tax so the earnings
are only taxed once—at the owners' marginal rates.
Unlike S corporations, partnerships permit special allocations
of tax attributes provided such allocations have substantial
economic effect. Such allocations can often help a business
raise equity capital from outside investors while enabling
the general partners to maintain control of the business.
Pass-through entities are often good choices for businesses
that are expected to generate losses in the early years
because the active owners ordinarily can apply those losses
against income from other sources.

Owner
Compensation:
An owner of a C corporation can be compensated through
salary, fringe benefits, pension and profit sharing plans,
and dividends. Of these types of compensation, dividends
are usually the least preferred because they are subject
to tax at both the entity and shareholder levels. Non-liquidating
distributions to shareholders are dividends to the extent
of corporate earnings and profits. The excess is treated
as a return of capital. Salaries, to the extent they are
reasonable in amount, are effectively taxed only once
(as income to the owner) because they are deductible by
the entity. Most types of fringe benefits and pension
and profit sharing plans receive tax-favored treatment
in that they can be funded with pre-tax dollars and often
do not generate current income to the recipient.

Because S corporations, partnerships and limited liability
companies taxed as partnerships are pass-through entities,
each owner is allocated a share of the entity's income
and other tax attributes based on the owner's ownership
interest. These items are then reported on the owner's
individual return. When an S corporation distributes property,
the owner/recipient generally recognizes gain only to
the extent the value of the property exceeds the owner's
stock basis. An S corporation may also compensate its
owners through salary. Salary is includible in the owner's
income and is deductible by the corporation.

A partner generally recognizes no gain or loss on a current
distribution of property by the partnership. There is
an exception with regard to the receipt of certain ordinary
income assets often referred to as hot assets. Also, a
partner receiving a cash distribution must recognize gain
to the extent that the amount received exceeds his basis
in his partnership interest. Like a corporation, a partnership
may compensate its owner/employees through salary. Salary
is includible in the owner's income and is deductible
by the partnership.

Fringe
Benefits:
A C corporation has the greatest ability to provide fringe
benefits on a tax-favored basis. Such benefits can include
life insurance (with limits), health insurance, certain
death benefits and meals and lodging in limited circumstances.
In addition, contributions by the corporation to a qualified
pension plan may also be deductible when made but not
currently taxable. The corporation can also set up a cafeteria
plan to let employees pick and choose fringe benefits.
This flexibility is much greater than that afforded partnerships
and S corporations.

In general, a partnership or a limited liability company
classified as a partnership may deduct the cost of providing
the benefit, but the owners must include the value of
such benefit in income. Thus, there is no real tax benefit
to either the entity or the owners. This same rule applies
to any shareholder in an S corporation who owns at least
2% of the corporation's stock.

These are some of the major issues that should be considered
when choosing a business form.